The growing presence of public and private insurers as purchasers of drugs may have distortionary effects on generic drug prices and pharmaceutical spending. Insurer reimbursement rules change the incentives for how pharmacies purchase generic drugs. In particular, reimbursement rules provide incentives for pharmacies to purchase higher priced versions of generic drugs, inducing generic manufacturers to compete for pharmacy market share by setting higher prices than their competitors. While this has important implications for pharmaceutical spending, there are no studies that systematically or quantitatively analyze these effects. The proposed research will investigate the distortionary effects of Medicaid drug reimbursement policies on generic drug prices, spending, and pharmacy purchasing. More specifically, the project will study the pharmacy and manufacturer responses to a unique policy intervention that caused a sharp decline in price for a well-defined set of generic drugs. Prior to the policy, very large differentals between Medicaid reimbursement rates and actual pharmacy purchase prices existed for many of these generic drugs. This natural experiment provides an opportunity to study the extent to which Medicaid reimbursement policies distort provider and manufacturer behaviors. The project will use Medicaid State Drug Utilization data from CMS for 1994-2004 which tracks drug utilization at the level of the National Drug Code (NDC) for the universe of Medicaid drug claims. The specific aims of the project are to: 1) quantify the extent to which pharmacies substitute among bioequivalent generic products in response to changes in Medicaid reimbursement and the broader consequences for pharmaceutical spending; 2) analyze how reductions in Medicaid reimbursement affect generic drug manufacturers' decisions to engage in other distortionary behavior such as strategically discontinuing targeted drug products and introducing reformulated, unregulated versions in order to raise prices; 3) assess how the distortionary effects of Medicaid reimbursement on market outcomes vary across drugs depending on the size of the market, number of generic competitors, and Medicaid market share. This research is the first to examine how reimbursement policies can distort the underlying competitive structure of the prescription drug market and their consequences for healthcare costs. Understanding the impact of reimbursement on provider behavior is highly relevant to policymakers seeking to reduce healthcare costs through alternative reimbursement policies while minimizing the distortions to the pharmaceutical market and prescription drug access for public insurance beneficiaries.